An extremist, not a fanatic

January 19, 2018

Outsourcing: a transactions cost approach

In all the reaction to Carillion’s collapse and the NAO’s report on PFI, one important perspective has for me been under-stated – that of transactions cost economics.

Let’s start with an important distinction – between private finance and private provision.

There is no justification for private finance of government projects. One thing the state can do better than the private sector is borrow cheaply. Private finance is the result of daft accounting rules described by Laurie MacFarlane rather than of economic rationality.

Private provision, however, is another matter. In principle, competitive tendering by private firms could bid down the cost to the tax-payer of government services.

But there’s a problem here. As Simon says, companies that win tenders by bidding low have an incentive to cut quality. The question is: is it possible to stop this happening?

It’s here that transactions cost economics enters. This perspective began with Ronald Coase’s famous essay, The Nature of the Firm (pdf). Whether we should do a job in-house or through the market depends upon the comparative costs. And, he said, “there is a cost of using the price mechanism.”

In our context, this cost is the difficulty or even impossibility of writing contracts which ensure good quality provision. As Oliver Hart put it:

It may be prohibitively expensive to write a contract that conditions quantity, quality and price…This is not just because some of the variables are privately observed, but also because, even if publicly observable, the variables are inherently hard to specify in advance. (Firms, Contracts and Financial Structure, p24)

Whether outsourcing is a good idea hinges upon whether this is the case or not. If a contract controlling outcomes adequately can be written, then outsourcing might work. But only might, because a contract demanding decent quality would be an expensive one. The NAO says (pdf):

Our work on PFI hospitals found no evidence of operational efficiency: the costs of services in the samples we analysed were similar…More recent data from the NHS London Procurement Partnership shows that the cost of services, like cleaning, in London hospitals is higher under PFI contracts.

And if we can’t write an adequate contract, the case for outsourcing is even weaker.

The answer here will differ from service to service. It should be possible to contract properly for building work, for example, because a competent inspector should be able to assess quality – though even this isn’t always the case. In other cases, though, quality isn’t so observable and controllable; this might well be true of social care (where much hinges upon the manner of the individual carer) or forensic science.

But why might in-house provision be cheaper? One consideration here is the public service ethos. If people are motivated by an idea of public service, they’ll do good jobs without oversight or detailed contracts. Good culture is potentially a cheap solution to the problem of incomplete contracts.

But only potentially. Such an ethos should not be taken for granted. The Stafford Hospital affair – and perhaps the “failure of leadership at all levels” in the prison service – remind us that it is sometimes dangerously lacking. Martin Wolf makes an important point (in a different but applicable context) when he reminds us that nationalized industries “ treated users with indifference.”

Which brings me to another question that’s overlooked: how can we build a true public sector ethos in which workers are, in Le Grand’s words, knights rather than knaves? (The answer might well include less managerialism and more empowerment of workers and users.)

It might be a good idea to reduce the amount of outsourcing; that depends not upon ideology but a cool-headed assessment of transactions costs. Doing so, though, should be a means to a greater end, and not just an end in itself.

"There is no justification for private finance of government projects. One thing the state can do better than the private sector is borrow cheaply."

whoa there!

Compare:

Trad procurement. Government borrows at 1% but must stump up for cost overruns

PFI. SPV borrows at 5% and if there are cost overruns first the SPV equity holders lose and then the SPV starts defaulting and the credits do.

I am not claiming this is how contracts are priced, but it's perfectly possible to have a scenario in which the expected cost to the government is *the same* under the two, despite that higher private sector borrowing cost. And if PFI costs more, that could be good value for money if the government values risk transfer, depends on what the risks look like and whether that 5% is a sensible price for bearing them. Look again at what the NAO says the benefits of PFI are - one is risk transfer meaning not having to cough up more money if things go awry. That 'schools cost 40% more' number everyone is citing is before benefits, which discussed next.

OK, you can write a fixed-price contract for conventional construction (and the construction firm will charge you accordingly for wearing the risk it cocks up, so may also 'cost more' than an open books cost-plus contract) but then you still have the incentive to skimp on quality left. The PFI design is supposed to encourage higher build quality (which is why cost comparisons are difficult) because they SPV doesn't want to be on hook for maintaining a shoddy building. The NAO report actually said standards of maintenance are found to be higher under PFI contracts, a point few people seem to be picking up.

None of the above suggests PFIs are good value because there are other problems to PFI one might add to the above, and anecdotally I am hearing about what sound like dreadfully written PFI contracts where e.g. maintenance costs are charged to the customer rather than being worn by the SPV, which defeats the whole purpose. But I think you've missed a big part of the story here Chris.

(the NAO notes the data for full lifetime cost comparisons do not exist)

further - it is not clear whether the expected returns (to lenders into the SPV and equity investors) quoted by the NAO are true expected returns - the footnote refers to a 'base case' - if that's an "if everything goes to plan" base case, I reckon that's potentially seriously misleading if, as above, the whole point is shifting who pays when risks materialise.

imo I don't see the construction cost saving - if anything desire to reduce future maintenance implies higher costs to me - place to look is the quality, I reckon.

NAO continues "these benefits must exceed the higher financing and other additional costs (see Fig 4 - which is the 40% more expensive schools example)

it's not clear to me if the 40% more expensive is a 'if things go to plan' number (i.e. missing the all important allocation of liability for cost overruns) but the fact that the NAO has framed this as 'the benefits may offset the higher cost' means that imo it's misleading just to say "wowsers the NAO says PFI costs 40% higher why on earth are we doing this?!" which is a take I have seen a lot.

I am not impressed with how The Guardian wrote this up - it's all costs and no benefits, just like e.g. the Daily Mail writing about refugees.

I would like to see data on realised risks e.g. how often to lenders into PFI SPVs actually lose money.

This 'the government can borrow more cheaply' line overlooks that both the government and SPVs are borrowing from private investors, question is what's stopping competition from driving down SPV loan pricing down so it's on the same risk-return frontier as government debt (i.e. not more expensive, just different risk profile)

if I had to bet, I'd bet that SPV lenders aren't really bearing the risks they oughta, and they are charging too much for it.

"I am not claiming this is how contracts are priced, but it's perfectly possible to have a scenario in which the expected cost to the government is *the same* under the two"

That's a fallacy of composition. The government is the source of all money - it owns the central bank - and so analysing it via a risk transfer mechanism is wrong.

The cost of money to government is net zero, but the cost of risk transfer is that people who are employed will become unemployed on failure. Which is simply moving accounts as far as the public sector is concerned. And of course no parliament can bind a successor, so the contract can simply be cancelled unilaterally by parliament in one to five years time.

PFI is a creature of the EU period - the idea that government is just some other business in the economy, rather than the peak of the hierarchy with first dibs over the real resources of the nation.

When government 'saves money' it taxes people, when it 'spends money' people get richer. Government accounting is that of a bank, not a firm.

I've been trying to think how I'm wrong. Aside from obvious gap between theory and practice. I think I could be wrong if you think the state ought to be risk neutral and that private lenders demand a risk premium (because they are not risk neutral).

But if you're running a departmental budget you're not risk neutral. Especially if politics punished failure.

Sure, this is all good stuff and well known and developed theory for neoclassical economists. People on all sides of these debates should read their Coase and their Gordon, Chicago boys as they are.

But doesn't the positive political economy, as distinct from normative economics, of it depend on who is the decision maker? No actual decision maker is a benevolent social planner operating behind the veil of ignorance.

So once again it all comes back to politics. PFIs are simply one way the Matthew effect works.

One thing that does not get mentioned in PFI involving construction is that the exact same pools of private designers and contractors are used whether it is a traditional Government run contract or a hands-off PFI contract. The actual risks for both methods are essentially the same.

Private sector risk management is not very advanced. They tend to list every risk that might occur, price up each and total them all up - the total is added to contract price. The Government pays for ALL the potential risks whether they occur or not. There is zero risk transfer.

The big risks are at the early 3 year stage not the final 22 years. When it gets into maintenance, then profits are made by re-financing at a lower rate than being paid and the client having to pay "£500 to change a light bulb" schedule type tasks (designed to fail early and often) which are tasks owned solely by the PFI monopoly contractor.

Many PFI contracts were sold on after the 3 year construction period for a guaranteed lucrative revenue stream over the next 22 years- some with 12% yields and meaning the original PFI contractor was paid several times more than he spent - zero risk again.

My local hospital had to be closed to cover the locked in costs for the one PFI hospital in the NHS Trust. PFI is little different from spending on a credit card - it costs much more in interest over 25 years at 8% than it would over 3 years at 5%. Over the 25 years it cost 4 times as much by PFI as traditional purchasing.

The Government insists all outsourcing is commercial-in-confidence so that all requests to find out what the actual costs and benefits are, are refused.

Carillion were originally a building contractor - what the heck do they know about all the other work areas they contracted for? Nothing - they subcontracted it all out - then on to sub-subcontractors until the last person standing knew something about the job. That person just guessed as to what was wanted because being so remote from the original contract and with no one sensible to be able to ask.

No one in the private sector has the expertise of the public Probationary Service - yet it was privatised - and surprise, surprise is now one of the long list of outsourcing failures that public money has to be thrown at to rescue.